Chapter 3 Securities Markets Bodie, Kane, and Marcus Essentials of Investments Tenth Edition 3.1 How Firms Issue Securities: Primary vs. Secondary Primary Secondary New Issue Created/Sold Current owner sells to another party Issuer Receives Issuer Does Not Proceeds from Sale Receive Proceeds from Sale Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2 3.1 How Firms Issue Securities: Private vs. Public Privately Held Publicly Traded Definition Ownership help by a small Securities sold to the group of investors general public; investors to trade shares Shareholders Up to 499 shareholders Financial Statements Fewer obligations to Obligated to release release financial financial statements to the statements to public public Primary Offering Sold Directly to a Small Sold to the Public (often group of Investors with an Underwriter) Unlimited number Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 3 3.1 How Firms Issue Securities: IPO • Publicly Traded Companies • Initial public offering: First sale of stock by a formerly private company • Underwriters: Purchase securities from issuing company and resell them • Prospectus: Description of firm and security being issued Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4 3.1 How Firms Issue Securities • Initial Public Offerings • Issuer and underwriter put on “road show” • Purpose: Bookbuilding and pricing • Underpricing • Post-initial sale returns average 10% or more—“winner’s curse” problem? • Easier to market issue; costly to issuing firm Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 5 Figure 3.1 Relationship among a Firm Issuing Securities, the Underwriters, and the Public Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6 Figure 3.2 Average First-Day Returns for (mostly) European IPOs Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7 Figure 3.2 Average First-Day Returns for Non-European IPOs Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 8 3.1 How Firms Issue Securities: Shelf Registration • SEC Rule 415 • Security is preregistered • May be offered at any time within the next two years • 24-hour notice: Any or all of preregistered amount may be offered • Introduced in 1982 Why would a firm use Rule 415? Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 9 3.2 How Securities Are Traded: Financial Markets • Overall purpose: Facilitate low-cost investment • Bring together buyers and sellers at low cost • Provide adequate liquidity •Minimize time to trade •Promotes price continuity • Set and update prices of financial assets • Reduce information costs associated with investing Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10 3.2 How Securities Are Traded: Market Types • Direct Search Markets • Buyers and sellers locate one another on their own • Brokered Markets • Third-party assistance in locating buyer or seller • Dealer Markets • Third party acts as intermediate buyer/seller • Auction Markets • Brokers and dealers trade in one location • Trading is more or less continuous Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 11 3.2 How Securities Are Traded: Order Types • Market order: Execute immediately at best price • Bid price: price at which dealer will buy security • Ask price: price at which dealer will sell security • Price-contingent order: Buy/sell at specified price or better • Limit buy/sell order: specifies price at which investor will buy/sell • Stop order: not to be executed until price point hit Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12 Figure 3.3 Market Orders: Average Market Depth •S&P 500: Large Capitalization Stocks •Russell 2000: Small Capitalization Stocks What does the difference in depth imply? Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 13 Figure 3.5 Price-Contingent Orders Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 14 3.2 How Securities Are Traded • Trading Mechanisms • Dealer markets • Over-the-counter (OTC) market: Informal brokers/dealers who negotiate securities sales network of • NASDAQ stock market: Computer-linked price quotation system for OTC market • Electronic communication networks (ECNs) • Computer networks that allow direct trading without market makers • Specialist markets • Specialist: Makes market in shares of one or more firms; maintains “fair and orderly market” by dealing personally Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 15 3.3 Rise of Electronic Trading: Timeline of Market Changes • 1969: Instinet (first ECN) established • 1975: Fixed commissions on NYSE eliminated • Congress amends Securities and Exchange Act to create National Market System (NMS) • 1994: NASDAQ scandal • SEC institutes new order-handling rules • NASDAQ integrates ECN quotes into display • SEC adopts Regulation Alternative Trading Systems, giving ECNs ability to register as stock exchanges Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 16 3.3 Rise of Electronic Trading: Timeline of Market Changes • 1997: SEC drops minimum tick size from 1/8 to 1/16 of $1 • 2000: National Association of Securities Dealers splits from NASDAQ • 2001: Minimum tick size $.01 • 2006: NYSE acquires Archipelago Exchanges and renames it NYSE Arca • SEC adopts Regulation NMS, requiring exchanges to honor quotes of other exchanges Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 17 Figure 3.6 Effective Spread vs. Minimum Tick Size Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 18 3.4 U.S. Markets • NASDAQ • Approximately 3,000 firms • New York Stock Exchange (NYSE) • Stock exchanges: Secondary markets where already-issued securities are bought and sold • NYSE is largest U.S. Stock exchange • ECNs • Latency: Time it takes to accept, process, and deliver a trading order Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 19 Figure 3.7 Market Share of Trading in NYSE-Listed Shares Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 20 3.5 New Trading Strategies • Algorithmic Trading • Use of computer programs to make rapid trading decisions • High-frequency trading: Uses computer programs to make very rapid trading decisions in order to compete for very small profits • Dark Pools • ECNs where participants can buy/sell large blocks of securities anonymously • Blocks: Transactions of at least 10,000 shares Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 21 3.6 Globalization of Stock Markets • Moving to automated electronic trading • Current trends will eventually result in 24- hour global markets • Moving toward market consolidation Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 22 Figure 3.8 Market Capitalization of Major World Stock Exchanges, 2014 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 23 3.7 Trading Costs • Commission: Fee paid to broker for making transaction • Spread: Cost of trading with dealer • Bid: Price at which dealer will buy from you • Ask: Price at which dealer will sell to you Spread = Price Ask − Price Bid • Combination: On some trades both are paid Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 24 3.8 Buying on Margin • Margin: Describes securities purchased with money borrowed in part from broker • Net worth of investor's account • Initial Margin Requirement (IMR) • Minimum set by Federal Reserve Regulation T, currently 50% for stocks under • Minimum % initial investor equity • 1 − IMR = Maximum % amount investor can borrow Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 25 3.8 Buying on Margin • Equity • Position value – Borrowing + Additional cash • Maintenance Margin Requirement (MMR) • Minimum amount equity can be before additional funds must be put into account • Exchanges mandate minimum 25% • Margin Call • Notification from broker that you must put up additional funds or have position liquidated Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 26 3.8 Buying on Margin • If Equity / Market value MMR, then margin call occurs Market Value - Borrowed MMR Market Value • Solve for market value • A margin call will occur when: Borrowed Market Value 1 − MMR Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 27 3.8 Buying on Margin The percentage margin is defined as the ratio of the net worth, or the “equity value,” of the account to the market value of the securities. To demonstrate, suppose an investor initially pays $6,000 toward the purchase of $10,000 worth of stock (100 shares at $100 per share), borrowing the remaining $4,000 from a broker. The initial balance sheet looks like this Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 28 3.8 Buying on Margin The initial percentage margin is If the price declines to $70 per share, the account balance becomes: The assets in the account fall by the full decrease in the stock value, as does the equity. The percentage margin is now Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 29 3.8 Buying on Margin If the stock value in the Example were to fall below $4,000, owners' equity would become negative, meaning the value of the stock is no longer sufficient collateral to cover the loan from the broker. To guard against this possibility, the broker sets a maintenance margin. If the percentage margin falls below the maintenance level, the broker will issue a margin call, which requires the investor to add new cash or securities to the margin account. If the investor does not act, the broker may sell securities from the account to pay off enough of the loan to restore the percentage margin to an acceptable level. Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 30 3.8 Buying on Margin Suppose the maintenance margin is 30%. How far could the stock price fall before the investor would get a margin call? Let P be the price of the stock. The value of the investor's 100 shares is then 100 P, and the equity in the account is 100P− $4,000. The percentage margin is (100P − $4,000)/100P. The price at which the percentage margin equals the maintenance margin of .3 is found by solving the equation which implies that P = $57.14. If the price of the stock were to fall below $57.14 per share, the investor would get a margin call. Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 31 3.9 Short Sales • Sale of shares not owned by investor but borrowed through broker and later purchased to replace loan • Mechanics • Borrow stock from broker; must post margin • Broker sells stock, and deposits proceeds/margin in margin account (you cannot withdraw proceeds until you “cover”) • Covering or closing out position: Buy stock; broker returns title to party from which it was borrowed Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 32 3.9 Short Sales Purchase of Stock Time Action Cash Flow* 0 Buy share − Initial price 1 Receive dividend, sell share Ending price + Dividend Profit = (Ending price + Dividend) – Initial price Short Sale of Stock Time Action Cash Flow* 0 Borrow share; sell it + Initial price 1 Repay dividend and buy share to replace share originally borrowed − (Ending price + Dividend) Profit = Initial price – (Ending price + Dividend) *Note: A negative cash flow implies a cash outflow. Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 33 3.9 Short Sales • Round Trips • Long position • Buy first, sell later • Bullish • Short position • Sell first, buy later • Bearish • “Round trip” is a purchase and a sale Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 34 3.9 Short Sales • Required initial margin: Usually 50% • More for low-priced stocks • Liable for any cash flows • Dividend on stock • Zero tick, uptick rule • Eliminated by SEC in July 2007 Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 35 3.9 Short Sales: Example Suppose you are bearish (pessimistic) on Dot Bomb stock, and its market price is $100 per share. You tell your broker to sell short 1,000 shares. The broker borrows 1,000 shares either from another customer's account or from another broker. The $100,000 cash proceeds from the short sale are credited to your account. Suppose the broker has a 50% margin requirement on short sales. This means you must have other cash or securities in your account worth at least $50,000 that can serve as margin on the short sale. Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 36 3.9 Short Sales: Example Let's say that you have $50,000 in Treasury bills. Your account with the broker after the short sale will then be: Your initial percentage margin is the ratio of the equity in the account, $50,000, to the current value of the shares you have borrowed and eventually must return, $100,000: Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 37 3.9 Short Sales: Example Suppose you are right and Dot Bomb falls to $70 per share. You can now close out your position at a profit. To cover the short sale, you buy 1,000 shares to replace the ones you borrowed. Because the shares now sell for $70, the purchase costs only $70,000. Because your account was credited for $100,000 when the shares were borrowed and sold, your profit is $30,000: The profit equals the decline in the share price times the number of shares sold short. Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 38 3.9 Short Sales: Example Suppose the broker has a maintenance margin of 30% on short sales. This means the equity in your account must be at least 30% of the value of your short position at all times. How much can the price of Dot Bomb stock rise before you get a margin call? Let P be the price of Dot Bomb stock. Then the value of the shares you must pay back is 1,000P, and the equity in your account is $150,000 − 1,000P. Your short position margin ratio is equity/value of stock = (150,000 − 1,000P)/1,000P. The critical value of P is thus Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 39 3.9 Short Sales: Example which implies that P = $115.38 per share. If Dot Bomb stock should rise above $115.38 per share, you will get a margin call, and you will either have to put up additional cash or cover your short position by buying shares to replace the ones borrowed. Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 40 3.10 Regulation of Securities Markets • Self-Regulation • The Sarbanes-Oxley Act • Insider Trading • Inside information: Nonpublic knowledge about a corporation possessed by officers, major owners, etc., with privileged access to information Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 41